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party's default on its payment obligations. The central government is exposed to credit risk because interest-rate and currency swaps are included in the management of the risk on the government debt. When a swap is transacted, its market value is zero, but over time the market value may become either positive or negative for the central govern- ment, depending on the development in interest and exchange rates. If the market value develops in favour of the central government it will have a credit exposure on the counterparty. If the counterparty goes into liquidation or defaults on the contract, the central government may lose its claim on the counterparty. The framework for the central government's credit management is outlined in Box 9.2. A more detailed account is included in the Appendices.

CENTRAL-GOVERNMENT CREDIT RISK MANAGEMENT Box 9.2

Key principles of central-government credit risk management:

• Counterparties must have high credit ratings

• In principle, swaps are transacted only with counterparties that have signed a unilateral collateral agreement

• Only standardised and simple interest-rate and currency swaps are used (plain vanilla)

• The swap volume is spread across counterparties

• Swaps can be terminated if the counterparty's rating falls below a certain level (rating triggers)

• Developments in counterparty stock prices and CDS spreads are monitored on an ongoing basis.

A counterparty must as a main rule be rated minimum Aa3/AA- by at least two well- reputed rating agencies. Since counterparties must maintain a high credit rating, the probability of losses is kept at a low level. If a counterparty defaults on its payment obligations, the unilateral collateral agreement (CSA) limits the central government's loss. The collateral agreement with the central government entails that the counterparty must pledge collateral if the market value of the swap portfolio exceeds a given threshold. The threshold is thus the upper limit for credit risk on a counterparty. This threshold value depends on the rating of the counterparty.

All agreements concluded between the central government and swap counterparties are based on the standardised ISDA Master Agreement, one element of which is rating triggers. Rating triggers entitle either party to terminate swaps if the rating of the other party falls below a certain level (normally A3/A-). Whether it is an advantage for the central government to terminate swaps depends on the credit exposure, the swaps' remaining term to maturity, the costs of termination, and how losses can otherwise be avoided, e.g. by increasing the collateral pledged.

Intensified monitoring of the central government's credit exposure The financial turmoil in 2008 highlighted the handling of the central government's credit risk. Uncertainty in relation to the credit rating of its swap counterparties has increased. A bank may now drop from a high to a very low rating – or even go bankrupt – considerably faster. For example, Lehman Brothers' rating was A+/A1 immediately before it filed for protection under Chapter 11.

As a result of the market turmoil, monitoring of the government's credit exposure has been intensified. Among other measures, the long- term ratings of the rating agencies are supplemented with monitoring of developments in counterparty stock prices and CDS spreads1

. Changes in stock prices and CDS spreads can give a quick indication of the counterparties' abilities to meet their payment obligations.

Counterparties assessed to involve greater risk are monitored more closely on an "observation list". Only in special circumstances are new swaps transacted with counterparties on this list.

The central government's swap portfolio in 2008

In 2008, the central government concluded 13 new swaps with a total principal of DKK 30 billion. Most of them were concluded in connection with foreign borrowing in dollars, which has been swapped to euro. In addition, currency swaps from kroner to dollars have been concluded for small amounts in connection with re-lending to Danish Ship Finance. At

1

A credit default swap, CDS, is a financial instrument used for hedging the credit risk on e.g. a company. The development in bank CDS spreads therefore reflects market assessments of the probability of the banks in question defaulting within a given period of time.

THE CENTRAL GOVERNMENT'S SWAP PORTFOLIO, 2006-08 YEAR-END Table 9.3.1

2006 20071

20082

Number of counterparties ... 24 20 21 Number of swaps ... 396 355 360

Principal, DKK billion

Interest-rate swaps, Danish kroner ... 75.1 65.4 64.6 Interest-rate swaps, other currencies ... 61.6 57.2 70.0 Currency swaps DKK-EUR, EUR-DKK ... 14.2 13.3 11.3 Currency swaps DKK-USD3 _{... 4.9 6.9 10.4} Currency swaps USD-EUR ... - - 13.2 Currency swaps, other ... 1.8 - 0.0 Structured swaps ... 0.2 - - Principal, total ... 157.8 142.8 169.5 1

Excluding swaps from the Mortgage Bank of the Kingdom of Denmark, which amounted to DKK 514 million at end-2007. 2

Excluding 1 swap from the Mortgage Bank of the Kingdom of Denmark, which amounted to DKK 35 million at end-2008. 3

end-2008, the swap portfolio comprised 360 swaps with 21 counterparties, with a total principal of DKK 170 billion, cf. Table 9.3.1. The development in the market value of the central government's swaps reflects fluctuations in interest and exchange rates. Interest-rate swaps are typically used to restructure debt from long to short duration, which means that the central government primarily pays interest at a floating rate and receives interest at a fixed rate. The market value of the government's portfolio of interest-rate swaps thus increases when interest rates decline.

The market value of the government's currency swap portfolio is primarily affected by the exchange rate of the dollar. In 2008, currency swaps were used in connection with foreign borrowing as well as re- lending in dollars to Danish Ship Finance. As a result of the fixed- exchange-rate policy, the central government's portfolio of currency swaps between kroner and euro does not give rise to major fluctuations in market value.

In 2008, the market value of the government's swap portfolio increased by DKK 3.3 billion, cf. Table 9.3.2, mainly as a result of falling interest rates.

Credit exposure of the swap portfolio

The credit exposure of the swap portfolio is calculated on the basis of the current exposure and the value of the collateral pledged. The current exposure is the sum of the positive market values stated on a net basis for the individual swap counterparties. In 2008, the credit exposure increased by DKK 1.7 billion to DKK 3.0 billion, cf. Chart 9.3.1.

NET MARKET VALUE OF THE SWAP PORTFOLIO Table 9.3.2

DKK billion End-2006 End-20071

End-20082

Interest-rate swaps ... 3.5 0.1 5.1 Currency swaps ... 0.2 0.4 -1.4

Structured swaps ... 0.0 - - Total ... 3.7 0.5 3.8 Note: The net market value of the swap portfolio is the sum of the market values of the individual swaps.

1

Excluding swaps transferred from the Mortgage Bank of the Kingdom of Denmark (market value DKK -37 million at end-2007).

2

Excluding 1 swap transferred from the Mortgage Bank of the Kingdom of Denmark (market value DKK 9 million at end-2008).

Swap counterparty diversification

The central government reduces the risk of losses by using a large number of swap counterparties. Furthermore, a large number of swap counterparties contributes to ensuring price competition. At end-2008 the outstanding swaps were distributed on 21 counterparties, of which one counterparty rated AAA had a market share of 14 per cent, cf. Chart 9.3.2.

CREDIT EXPOSURE ON THE GOVERNMENT SWAP PORTFOLIO Chart 9.3.1

-12 -8 -4 0 4 8 12 16

Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09

Credit exposure Current exposure Collateral

DKK billion

SWAP PORTFOLIO BROKEN DOWN BY THE CENTRAL GOVERNMENT'S

COUNTERPARTIES Chart 9.3.2 0 2 4 6 8 10 12 14 16 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 AAA AA AA- A+ to A- Per cent

Credit quality in 2008

The central government's credit exposure in 2008 was distributed on counterparties with lower ratings than in previous years. At end-2008, 30 per cent of the credit exposure was distributed on counterparties rated AAA, a drop by almost 15 percentage points from the previous year, cf. Chart 9.3.3.

During 2008, Fitch Ratings, Moody's and Standard & Poor's performed a total of 38 downgradings of 12 of the central government's counter- parties. Of the six most frequently used counterparties at end-2008, with a total market share exceeding 50 per cent, four were downgraded in 2008. Three of them were downgraded two levels from AA to A+, so that the volume of outstanding swaps with counterparties rated A+ has increased considerably.

Updating the central government's credit risk management

Central-government credit-risk management has been adjusted only slightly since the introduction of unilateral collateral agreements in the late 1990s. As this area is subject to constant development, Government Debt Management in 2008 began to update the government's credit-risk management. This is done with a view to reducing the credit exposure on the government debt and introducing simpler, more up-to-date credit-risk handling.

THE CENTRAL GOVERNMENT'S CREDIT EXPOSURE BY COUNTERPARTY

RATING Chart 9.3.3 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 2007 2008

AAA AA- to AA+ A- to A+

DKK billion

The first updates were implemented in the spring with a switch to daily, rather than monthly, adjustment of the collateral. This limits the credit exposure and simplifies credit-risk management as it is no longer relevant to take into account developments in the potential credit exposure.

Towards the end of 2008, Government Debt Management began to renegotiate all existing collateral agreements (CSA). Under the current agreements, the counterparty must pledge securities as collateral when the market value of the swap portfolio exceeds a threshold value. The threshold value depends on the rating of the counterparty. In the renegotiations, importance is attached to limiting the overall credit exposure by reducing the threshold values to zero. A lower threshold means that the central government's counterparties must pledge more collateral when the market value of the swaps concluded develops in favour of the government.

A lower threshold implies higher administration costs due to more frequent pledging of collateral. This issue can be addressed by raising the minimum amount to be transferred when adjusting the collateral (the minimum transfer amount). The new CSA envisages raising the minimum transfer amount and linking it to the counterparty's rating.

OPERATIONAL RISK 9.4

Government Debt Management is divided into front, middle and back offices. A clear division of functions reduces operational risk and facilitates internal control. Moreover, only standardised, well-known financial instruments are used, and legal risk is minimised by exclusively using standardised contracts.

Procedures have been defined for the individual tasks, and all procedures are maintained on an ongoing basis and approved by the manager in charge.